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Understanding Simple Interest and Compound Interest

Interest is the cost that must be paid when ones borrowing money. There are two types of interest. Those two types differ in how the interest is calculated. They are simple interest and compound interest. Simple interest is calculated on the loan principal amount. And the compound interest is also regarded as interest of interest. It is calculated on the loan principal amount and on the accumulation of interest from earlier periods.

At a glance, it can be assumed that simple interest is more affordable and advantageous for borrowers. However, for investors, it is more advantageous to get compound interest from the bank. To understand about those two types of interest, you need to know the difference between simple interest and compound interest formula.

For example, one borrows $5000 with 8 % interest rate for three years. The simple interest is calculated below.

I = 5000 x 0.08 x 3

I = 1200

Compound interest formula is I = p x r x 1 for the first year.

Example: I = 5000 x 0.08 x 1

I = 400

For the second year, it is I = (p + 1st year interest) x r x 1.

Example: I = 5400 x 0.08 x 1

I = 432

And for the third year, the formula is I = (p + 1st year interest + 2nd year interest) x r x 1.

Example: I = 5832 x 0.08 x 1

I = 466.56

From the formulas above, we can conclude that compound interest yield more money than simple interest. Simple interest is usually applied on mortgage and car loans. Meanwhile, credit card companies apply compound interest.